As of this writing, value stocks have underperformed growth stocks for the second longest stretch in recorded history. For a big reason that many investors don’t see, this underperformance could continue for years to come, which makes risk control measures more important than ever.
Long-term investing advocates don’t seem to grasp why growth stocks could continue their historic streak of beating value. But those advocates are developing a newfound sense of risk control anyway, if only from a subconscious survival instinct.
Holding for the long term is still a good idea — as long as things are headed in the right direction. For individual stocks the “buy and hold” mantra is going out of fashion; instead the ability to sidestep disasters is becoming more paramount. This is a positive development, and worth discussing in detail.
Let’s start with a closer look at the underperformance of value versus growth. As reported by James Mackintosh in The Wall Street Journal, via the research of professor Kenneth French at the Dartmouth Tuck School of Business, a classic quant strategy of being long inexpensive value stocks and short expensive growth stocks has now lost money, with very brief daylight intervals, for 12 years straight.
Even for faithful stoics, 12 years is a long time to be out in the cold. Value stocks were a severe underdog to growth stocks during the dot-com era, but the pain didn’t stretch out this long. In fact, the only period where value underperformed growth for a longer window of time, according to French, was during the Great Depression.
To make the sting worse, Mackintosh points out that value stocks still aren’t cheap in 2019. “At 2.3 times book at the end of February,” he wrote, “value stocks were at the same multiple as the wider market was just before the Black Monday crash in 1987.”
The reason growth could beat value for years yet to come, as we explained in our breakdown of the Kraft-Heinz debacle, is because the nature of “moats” has changed.
The old moats were simple and static. The new moats are complex and dynamic. This puts all manner of companies under threat, and makes value investing a more perilous proposition than it once was.
When the rate of technological and sociological change was slow — or at least slower than it is now — it was a lot easier to invest in value stocks as a general rule, because business models weren’t so readily exposed to obsolescence or extinction.
If a company stumbled in years past, it had a fair shot of dusting itself off and getting back on track. Now, that same company’s business model could be food for an apex predator. That makes it hard to tell the difference between a temporary problem or a cyclical downturn, both of which are investable, and a roadkill situation in which the company, or the industry, never comes back.
The dominance of the tech giants — Facebook, Amazon, Google, and so on — has also shifted the profit landscape in favor of growth over value. It is because of these companies, and the gusher of profits they create, that growth stocks haven’t fallen behind in recent years. As Mackintosh writes:
“Expensive stocks are almost always priced at a premium because of their growth potential, but throughout history, that premium was too big: Their earnings did grow faster than the wider market, but not fast enough to justify such high prices. The past decade has been different, as growth stocks beat earnings expectations. Trendy big companies such as Apple, Facebook and Alphabet are obvious examples, but in virtually every sector, the strong companies have grown stronger, and value investors missed out on them.”
In a nutshell, the explosion of technological advances and sociological change we are seeing now favors a “winner take all” dynamic in which, while a great many companies fall behind, the handful of winners who get it right have the potential to dominate on a scale never before seen.
In his famed Intelligent Investor column that runs in the WSJ each Saturday, long-term investing advocate Jason Zweig gets the new landscape somewhat backwards — but comes to a useful conclusion anyway.
Zweig’s March 15, 2019, column was titled, “The Hidden Risk When You Own Stocks for the Long Run.” It carried this equally provocative subtitle: “Now more than ever, investors need to decide whether they want to lock up their money in bets that could pay off richly — or fail disastrously — down the road.”
This is very true, given the landscape we have just described. Now more than ever, a huge gap exists between companies on their way to dominance and companies on their way to obsolescence or extinction.
But Zweig’s column oddly focuses on the spending of the tech giants as if they are the ones to worry about, as opposed to the penny-pinchers who wind up obsolete.
“Tech companies — which epitomize the long-term view today — are spending money on the future like there’s nothing but tomorrow,” Zweig writes, adding that: “All three companies [Alphabet, Amazon, and Facebook] are funding those expenditures from the oceans of cash their businesses generate.”
That is correct. But the tech giants have no choice.
On the one hand, these companies have huge ambitions, with the potential to grow their net profits by a factor of 10x to 100x from today’s levels.
On the other hand, these companies live in mortal fear of each other. There is enough overlap between the play space of the tech giants that if one of them stumbles or falls behind, the others could eat its lunch.
The way to compete in a “Game of Thrones” environment, like the space the tech giants now occupy, is not to hunker down and cut expenditures. It is to continue building and growing and iterating as intelligently as you can, lest someone else conquer your kingdom.
This general dynamic also explains why, against a backdrop of fast-moving change, the companies to worry about are the ones that are not spending notably from their accumulated profits.
On the one hand, share buybacks signal that a company is trying to be responsible and do right by its shareholders. On the other hand, those same buybacks may signal the company is out of ideas and dangerously short of new opportunities for innovation and growth.
Again, it didn’t used to be this way. In the past, companies could justify being tight-fisted and static, sticking with the same business model and pinching pennies, because competitor threats were neither existential nor coming in from surprise angles. It’s not that way anymore. The technological rate of change has accelerated too much, and continues to increase.
If you are in a business that Amazon or Google or Facebook decides to go after, there is a risk your profits will be eaten. There is little risk of anyone eating the profits of the tech giants — except via one of the other tech giants.
Strangely, this explains why the divergence of multiples could move even more extremely in favor of growth stocks, and the tech giants specifically, even in a stagnating bear market.
If the tech giants continue to earn sizable profits in a recession, their shares could become bizarro-world value stocks and inflation-proof stores of value — bizarro because their valuation multiples could rise to levels that appear insane to those who don’t grasp what is happening.
Is this certain to happen? Of course not. Nothing is certain but death and taxes.
And yet, the outlook of winning tech giants continuing to win — and seeing their valuations run higher, even as traditional value sinks into the muck — is actually more plausible than value stocks as an asset class suddenly surging back into favor.
The point here is less to make a forecast and more to say the long-term notion of “buy and never sell” needs to go away. There is no individual stock that is truly “set it and forget.”
The market provides no safety. It is good that high-profile, long-term investing advocates, like Jason Zweig, are starting to acknowledge this — even if they start with an odd focus.
There is no longer any value stock so chock full of value that an investor can hold it without worry, unless they are willing to let the stock price hit zero.
Nor can the tech giants be considered “buy and never sell” without scrutiny, because Zweig is correct; if they miss the mark in their future goals, valuations could fall dramatically.
All of this underscores why risk control is now more important than ever. Excellent investing opportunities will always exist. But the heightened opportunities of today and tomorrow are juxtaposed against sharply heightened risks.
The best way to implement risk control in your investing process is to use a set of tools and rules that functions the same way every time, without room for second guessing if a time-tested rule is triggered.
This is one of the areas where algorithms and software can provide a powerful assist to the human element. In TradeStops, we have made it easy to observe and manage risk based on changes in volatility, as indicated by a simple and intuitive green-yellow-red Stock State Indicator (SSI) system.
And, in Ideas by TradeSmith, we have deployed algorithms to identify the potential up-and-coming winners in today’s technology-dominated landscape.
In this strange market ocean we are sailing on, both the promise and the peril of investing has increased. TradeSmith is here to help you navigate profitably and safely.